An Information Quality-Based Explanation for Loan Loss Allowance Inadequacy during the 2008 Financial Crisis

Abstract

I study whether commercial banks’ loan loss allowances were inadequate during the 2008 financial crisis because bank managers relied on low-quality information to estimate loan losses. To measure the quality of information collected on bank-held mortgages prior to the crisis, I create a bank exposure-to-mortgage fraud risk index (EFI) that captures overstatement of borrower income in mortgage applications. I find banks that originated more loans in high-risk neighborhoods had less adequate loan loss allowances during the crisis. My study is consistent with the hypothesis that fraudulent borrower information adversely affected banks’ loan loss provisioning.

Keywords: Banks, Loan Loss Allowances, Information Quality, Reporting Transparency, Mortgage Fraud, the 2008 Financial Crisis

JEL Classification: G01, G21, M41, R30